Chapter 31 –

Business Valuation

Copyright © 2019 McGraw Hill Education, All Rights Reserved.

PROPRIETARY MATERIAL © 2019 The McGraw Hill Education, Inc. All rights reserved. No part of this PowerPoint slide may be displayed, reproduced or distributed in any form or by any
Copyright © 2019
means, without the prior written permission of the publisher, or used beyond the limited distribution to teachers and educators permitted by McGraw Hill for their individual course
preparation. If you are a student using this PowerPoint slide, you are using it without permission.
 Learning Objectives
• Explain the basic valuation framework in terms of different concepts of value—
book value, market value, intrinsic/economic value, liquidation value,
replacement value, salvage value and fair value
• Describe the four major approaches to valuation of business—asset-based,
earnings-based, market-value-based and fair value-based
• Discuss market value added (MVA) and economic value added (EVA) approaches
to measure value with focus on shareholders

Copyright © 2019
 Introduction
• The term ‘valuation’ implies the task of estimating the worth/value of an asset, a
security or a business.
• The price an investor or a firm (buyer) is willing to pay to purchase a specific asset/
security would be related to this value.
• A seller would consider the negotiated selling price of the asset/ business to be greater
than the value of the asset/ business he is selling.

Copyright © 2019
 Conceptual Framework of Valuation
• In the case of business valuation, the valuation is required not only of tangible
assets (such as plant and machinery, land and buildings, office equipments, and
so on).
• But also of intangible assets (like, goodwill, brands, patents, trademark and so
on).
• As well as human resources that run/ manage the business.

Copyright © 2019
 Book Value
• Book value is the value at which assets are shown in balance sheet.
• Generally, the sum is equal to the initial acquisition cost of an asset less
accumulated depreciation.
• Accordingly, this mode of valuation of assets is as per the going concern principle
of accounting.

Copyright © 2019
 Market Value
• Market value refers to the price at which an asset can be sold in the market.
• Market value of a business refers to the aggregate market value (as per stock
market quotation) of all equity shares outstanding.
• The market value is relevant to listed companies only.

Copyright © 2019
 Intrinsic/Economic Value
• Intrinsic (economic) value is the present value of incremental future cash inflows
using an appropriate discount rate.
• It represents the maximum price the buyer would be willing to pay for such an
asset.
• The principle of valuation based on the dis-counted cash flow approach
(economic value) is used in capital budgeting decisions.

Copyright © 2019
 Liquidation Value
• Liquidation value is the price at which an asset can be sold if the firm is
liquidated.
• In operational terms, the liquidation value of a business is equal to the sum of (i)
realisable value of assets and (ii) cash and bank balances minus the payments
required to discharge all external liabilities.

Copyright © 2019
 Replacement Value
• Replacement value in the cost of acquisition of a new asset of equal utility.
• It is normally useful in valuing tangible assets such as office equipment and
furniture and fixtures, which do not contribute towards the revenue of the
business firm.

Copyright © 2019
 Salvage Value
• Salvage value represents realisable/ scrap value on the disposal of assets after the
expiry of their economic useful life.
• It may be employed to value assets such as plant and machinery.
• Salvage value should be considered net of removal costs.

Copyright © 2019
 Value of Goodwill
• The valuation of goodwill is conceptually the most difficult.
• The value of goodwill is equivalent to the present value of super profits (likely to
accrue, say for ‘n’ number of years in future), the discount rate being the
required rate of return applicable to such business firms.

Copyright © 2019
 Fair Value
• Fair value is the average of book value, market value and intrinsic value.
• The fair value is hybrid in nature and often is the average of these three values.
• In India, the concept of fair value has evolved from case laws and is applicable to
certain specific transactions, like payment to minority shareholders.

Copyright © 2019
 Approaches/ Method of Valuation

• The major approaches to valuation of business with focus on equity share

valuation are:
 asset based approach to valuation,
 earnings based approach to valuation,
 market value based approach to valuation and
 the fair value method to valuation

Copyright © 2019
 Asset-Based Approach to Valuation
• Asset-based approach focuses on determining the value of net assets from the
perspective of equity share valuation.
• What should the basis of assets valuation be, is the central issue of this approach.
• It should be determined whether the assets should be valued at book, market,
replacement or liquidation value.
• The net assets valuation based on book value is in tune with the going concern
principle of accounting.
• In contrast, liquidation value measure is guided by the realisable value available
on the winding up/liquidation of a corporate firm.

Copyright © 2019
 Net assets = Total assets – Total external liabilities
Net assets per share = Net assets/Number of equity shares issued and outstanding

• In the case of book value, assets and liabilities are taken at their balance sheet values.
• In the market value measure, assets shown in the balance sheet are revalued at the
current market prices.
• Liquidation value is the final net asset value (if any) per share available to the equity
shareholder.
• The value is given as per the following equation:
Net assets per share = (Liquidation value of assets – Liquidation expenses – Total external
liabilities)/Number of equity shares issued and outstanding.

Copyright © 2019
• The asset based approach is intuitively appealing in that it indicates the net assets
backing per equity share.
• However, the approach ignores the future earnings/cash flow generating ability
of the company’s assets.
• In fact, the assets acquisition by business firms are not an end in themselves;
they are means to an end.

Copyright © 2019
 Earnings Based Approach to Valuation
• The earnings approach is essentially guided by the economic proposition that business
valuation should be related to the firm’s potential of future earnings or cash flow
generating capacity.
• Earnings can be expressed in the sense of accounting as well as financial management.
• Accordingly, there are two major variants of this approach:
 earnings measure on accounting basis and
 earnings measure on cash flow (financial management) basis.

Copyright © 2019
 Earnings Measure Based on Accounting —
Capitalisation Method
• As per this method, the earnings approach of business valuation is based on two major
parameters, that is, the earnings of the firm and the capatilisation rate applicable to
such earnings (given the level of risk) in the market.
• The following equation, can be used to compute the value of business, , (from the
perspective of share owners).
= Future maintainable profits ÷ Relevant capitalisation factor

Copyright © 2019
 Price Earnings (P/E) Ratio
• The P/E ratio (also known as the P/E multiple) is the method most widely used by
finance managers, investment analysts and equity shareholders to arrive at the market
price of an equity share.
• The application of this method primarily requires the determination of earnings per
equity share (EPS).
• The EPS is computed as per equation:
EPS = Net earnings available to equity shareholders during the period/ Number of equity
shares outstanding during the period.

Copyright © 2019
 Earnings Measure on Cash Flow Basis
(DCF Approach)
• Discounted cash flow approach is used to evaluate capital expenditure proposals in
terms of their potential for creating net present value for the firm.
• The DCF approach is applied to the entire business, which may consist of individual
capital budgeting projects.
• Accordingly, the value of business/firm is equal to the present value of expected future
cash flows (CF) to the firm, discounted at a rate that reflects the riskiness of the cash
flows ().
• In equation terms:

• Among the various variants of the earnings approach, the DCF approach (that is, free
cash flows) seems to be conceptually superior for business valuation as well as equity
valuation.
Copyright © 2019
 Market Value Based Approach to
Valuation
• The market value, as reflected in the stock market quotations, is another method
for estimating the value of a business.
• The market value of securities used for the purpose can be either
 twelve months average of the stock exchange prices or
• The average of the high and low values of securities during a year. The major
problem with this method is that the market value of a firm is influenced not
only by financial fundamentals but also by speculative factors.
• As a result, this value can change abruptly due to speculative influences, market
sentiments and personal expectations.
• Market makers as well as other ‘willing buyers or sellers’ (interested in purchases
or sales) can at times significantly influence these prices.

Copyright © 2019
 Fair Value Method
• The fair value method is not an independent method of share valuation like those
discussed above.
• This method uses the average/weightage average or one or more of the above
methods.
• Since this method uses the average concept, its virtue is that it helps in
smoothening out wide variations in estimated valuations as per different methods.
• In other words, this approach provides, in a way, the ‘balanced’ figure of valuation.

Copyright © 2019
Other Approaches to Value Measurement
• In recent years, a number of new approaches/techniques/methods to measure
value (with focus on shareholders) have been developed and practised.
• The two major approaches are market value added (MVA) and economic value
added (EVA).

Copyright © 2019
 Market Value Added Approach (MVA)

• The MVA approach measures the change in the market value of the firm’s equity vis-à-vis
equity investment (consisting of equity share capital and retained profits).
• Accordingly,
MVA = Market value of firm’s equity – Equity capital investment/funds

Copyright © 2019
 Economic Value Added (EVA)
• The EVA method is based on the past performance of the corporate enterprise.
• Economic value added (EVA) implies the difference between operating profits
after taxes and total cost of funds.
• In operational terms, the method attempts to measure economic value added (or
destroyed) for equity shareholders, by the firm’s operations, in a given year.
• The EVA is given by following equation:
EVA = [Net operating profits after taxes – (Total capital × WACC)]
or
EVA = Earnings after taxes – (Cost of shareholders funds)

Copyright © 2019